Gifting: carryover basis
When you give real property to someone during your lifetime, the recipient receives your carryover basis — they step into your tax shoes. If you bought a rental for $200,000, claimed $70,000 of depreciation, and gifted it with a FMV of $500,000, the recipient's adjusted basis is $130,000 (your $200,000 original basis minus the $70,000 depreciation). When they eventually sell for $500,000, they owe tax on the full $370,000 gain — including $70,000 of depreciation recapture taxed at up to 25%.
Annual gift tax exclusion: gifts up to $18,000 per donee per year (2024, indexed for inflation) are exempt from gift tax and require no reporting. Amounts above the exclusion count against the lifetime exemption. No gift tax is due until lifetime gifts exceed the exemption amount; at death, the remaining lifetime exemption applies against the estate.
Inheriting: stepped-up basis
When a beneficiary inherits real property, the basis is stepped up (or occasionally down) to fair market value on the date of death under IRC Section 1014. Using the same example: the heirs inherit the rental with a $500,000 basis. When they sell for $500,000, there is zero capital gain and zero depreciation recapture — all of it wiped out. The $70,000 of accumulated depreciation simply disappears.
This is the core of the “swap till you drop” estate strategy: continue exchanging into larger properties, deferring all tax, and at death the stepped-up basis eliminates every dollar of deferred gain and recapture.
When gifting makes sense
Gifting is still useful: (1) if the recipient has a lower tax rate than you, the family unit pays less total tax when they sell; (2) to transfer future appreciation out of your estate (gifts lock in today's value for estate-tax purposes); (3) for fractional interests in an LLC, discount valuation strategies can reduce the gifted value for gift-tax purposes. For properties with large accumulated depreciation or substantial built-in gain, holding until death is generally more tax-efficient unless specific estate-planning goals override the tax analysis.
Frequently asked questions
What basis does someone receive when they inherit real estate?
The basis steps up to the property's fair market value on the date of the owner's death, eliminating all built-in gain and accumulated depreciation recapture.
What basis does someone receive when given real estate as a gift?
The recipient receives the donor's carryover adjusted basis — including any accumulated depreciation deductions. All of the donor's embedded gain and recapture potential transfers with the gift.
Can I avoid depreciation recapture by gifting a rental property?
No. The recapture potential transfers to the gift recipient. The only way to permanently eliminate recapture is through the step-up in basis at death.
Sources
- IRS Topic No. 409 — Capital Gains and Losses
- IRS Publication 544 — Sales and Other Dispositions of Assets
Educational information and estimates only. Not tax advice. Tax rules change and vary by situation; consult a qualified tax professional before acting.